More workers are taking money from their 401(k) accounts early and using the hardship withdrawal rules to give them access to needed cash. The lingering high unemployment rate and slew of home foreclosures have been major factors.

Companies with retirement plans are reporting a rise in the number of workers who are withdrawing money early. Last year, 6.9 percent of 401(k) account-holders made a withdrawal, near the record high of 7.1 percent in 2009. About 20 percent of the withdrawals were for hardships.

Before the 2008 economic downturn, about 5 percent of workers withdrew money from their account each year.

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Some 63 percent of retirement plans experienced an increase in hardship withdrawals in the past two years, according to research by business consultant Aon Hewitt.

The most frequently cited reason for hardship withdrawals last year was to avoid a home eviction or foreclosure.

Banks are on track to repossess about 800,000 homes this year. That’s down from more than 1 million last year, according to RealtyTrac Inc., a foreclosure listing firm.

Because hardship withdrawals require the worker to pay taxes and a 10 percent penalty on the money taken out, it should be viewed as a last resort, said Cheryl Krueger, an actuary and financial adviser with Schaumburg, Ill.-based Growing Fortunes Financial Partners.

“Is this something you really ought to be considering,” she said workers need to ask themselves.

It’s natural that a worker facing a home foreclosure may want to take money out of the 401(k) to hold off the bank for a while. But Kruger said if it only temporarily delays an inevitable foreclosure, using retirement money doesn’t make sense.

The concern is that a 401(k) plan is protected from creditors, so using those funds in a manner that may not save the home is counterproductive, she said. “You really need good advice from somebody looking at the full picture,” she said, “and who understands the 401(k) rules and foreclosure or bankruptcy.”

Removing money from a retirement account permanently reduces the savings and diminishes what it can earn over time. As a result, some roadblocks have been placed in the way of workers to discourage them from pulling money out.

When 401(k) accounts were developed it was agreed upon that some mechanism was needed for workers to access the money in emergencies. Without that, many workers likely would not save.

Hardship defined

The Internal Revenue Service, which oversees collecting taxes on retirement funds, defines a hardship as an immediate and heavy financial need.

It also makes clear the worker must have exhausted other financial resources first. That includes bank loans and tapping the assets of a spouse and even minor children. Workers also must have already exhausted any other distribution and loan possibility with their employer’s retirement plan.

The IRS classifies six expenses as hardships and most plans follow these guidelines when considering whether a request meets the immediate and heavy need requirement. They include certain medical expenses, the cost of buying a family’s principal home, college costs, payments necessary to avoid eviction or foreclosure, burial expenses, and certain expenses for the repair of damage to the employee’s principal residence.

The IRS has periodically made special exceptions to some of the hardship withdrawal rules. Victims of hurricanes Katrina, Rita and Wilma were given a break, for example. Anyone with extensive damage from such a natural disaster should inquire about whether there’s an exception for their situation.

How it works

An employee seeking to take a hardship withdrawal will need to contact the person in their company responsible for managing the 401(k) program. There will be an application process during which the worker will have to demonstrate the hardship. In the case of a home foreclosure, for example, the bank documents will need to be provided including the amount owed.

The worker also will need to demonstrate other borrowing and resources have been tapped and the withdrawal is the last resort.

Employees considering a hardship withdrawal need to review the rules of their company’s plan because they can differ from one company to another.

The downside

In addition to the taxes and penalties, early withdrawals mean the account balance has been immediately reduced and removed the ability of that money to work over time.

Accountholders also likely will be prohibited from contributing more money to the account for six months after taking the withdrawal, further cutting into what’s accumulated.

A 401(k) loan

For workers who feel their job is reasonably secure, a loan against the 401(k) account is an option to help get them over a tough financial spot.

Loans were used by 28 percent of 401(k) participants last year, a record high.

It should be noted that a 401(k) loan is usually due within 60 days of job termination. If it’s not repaid, the money is treated as an early withdrawal and taxes and the 10 percent penalty must be paid. A very high number — about 70 percent — of workers with loans who lose their jobs default on the loan, so it’s important to assess one’s job security before considering a loan.